Dealer Liquidity Provision and the Breakdown of the Law of One Price: Evidence from the CDS–Bond Basis

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Dealer Liquidity Provision and the Breakdown of the Law of One Price : Evidence from the CDS–Bond Basis. / Choi, Jaewon; Shachar, Or; Shin, Sean.

julkaisussa: Management Science, Vuosikerta 65, Nro 9, 09.2019, s. 4100-4122.

Tutkimustuotos: Lehtiartikkelivertaisarvioitu

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Choi, Jaewon ; Shachar, Or ; Shin, Sean. / Dealer Liquidity Provision and the Breakdown of the Law of One Price : Evidence from the CDS–Bond Basis. Julkaisussa: Management Science. 2019 ; Vuosikerta 65, Nro 9. Sivut 4100-4122.

Bibtex - Lataa

@article{8785c1af15c24324926f0aadf13e8e52,
title = "Dealer Liquidity Provision and the Breakdown of the Law of One Price: Evidence from the CDS–Bond Basis",
abstract = "We examine dealers’ liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS–bond basis). However, dealers cut back on liquidity provision as they suffer losses, mispricing becomes wider, or the funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following the Lehman collapse were very low for bonds with strong preexisting basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.",
keywords = "CDS–bond basis, OTC market liquidity, limits to arbitrage, liquidity provision, corporate bonds",
author = "Jaewon Choi and Or Shachar and Sean Shin",
year = "2019",
month = "9",
doi = "10.1287/mnsc.2017.3011",
language = "English",
volume = "65",
pages = "4100--4122",
journal = "Management Science",
issn = "0025-1909",
number = "9",

}

RIS - Lataa

TY - JOUR

T1 - Dealer Liquidity Provision and the Breakdown of the Law of One Price

T2 - Evidence from the CDS–Bond Basis

AU - Choi, Jaewon

AU - Shachar, Or

AU - Shin, Sean

PY - 2019/9

Y1 - 2019/9

N2 - We examine dealers’ liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS–bond basis). However, dealers cut back on liquidity provision as they suffer losses, mispricing becomes wider, or the funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following the Lehman collapse were very low for bonds with strong preexisting basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.

AB - We examine dealers’ liquidity provision against mispricing in the corporate bond market from 2005 to 2009. Dealers on average serve as stabilizing liquidity providers by trading against widening price gaps between corporate bonds and credit default swaps (the CDS–bond basis). However, dealers cut back on liquidity provision as they suffer losses, mispricing becomes wider, or the funding situation worsens, consistent with the limited capital capacity of financial intermediaries. We also show that the unwinding of basis arbitrage trading can amplify mispricing by documenting that bond returns following the Lehman collapse were very low for bonds with strong preexisting basis arbitrage activity and for bonds underwritten by Lehman Brothers. Liquidity demand due to the exit of arbitrageurs can be a major driver of disruption in credit markets.

KW - CDS–bond basis

KW - OTC market liquidity

KW - limits to arbitrage

KW - liquidity provision

KW - corporate bonds

U2 - 10.1287/mnsc.2017.3011

DO - 10.1287/mnsc.2017.3011

M3 - Article

VL - 65

SP - 4100

EP - 4122

JO - Management Science

JF - Management Science

SN - 0025-1909

IS - 9

ER -

ID: 29690991